What Millennials Need to Know About Saving for Retirement

"Broke Millennial" author Erin Lowry breaks down the basics of planning and investing for your future.

Young AAA Member reviews her retirement plan.
Set aside time to create or update your retirement savings plan.
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The first thing you need to know about saving for retirement is that you’re actually doing more than that: You’re investing in your future. Whether you put money into a 401(k) or an IRA, you get to choose how your money grows, rather than simply setting funds aside to languish in a low-interest savings account. Why go to the trouble? The reason is pretty simple: Compound interest can grow your investment considerably over time. 

Time is one of the biggest advantages you can have as an investor. The longer you hang onto your investments, the greater their potential for growth and the more resilient they are to market fluctuations (because they have years to recover before you retire). That means Millennials—anyone born between 1981 and 1996—who start now can still build a sizable nest egg, despite the weight of student loans, the uncertainty around Social Security, and the scarcity of careers with pensions. 

It’s on us to take control and plan for our futures. To that end, here’s everything you need to know about saving for retirement.

When should I start saving for retirement?

Yesterday. OK, that’s a little melodramatic, but truly the sooner you start, the better off future you will be. Even if you’re paying back student loans, it absolutely makes sense to start investing now by setting aside at least a little money each month in a retirement account such as a 401(k) or an IRA. 

Here’s why: You know the sinking feeling that, despite regularly paying down debt, your principal balance isn’t shrinking? That’s compound interest working against you. With investing, you can make it work for you over time. Any sum can do a lot more work in an extra five or 10 years.

Let’s say that, at age 25, you start diligently putting $400 per month into a 401(k) and continue to do so for 40 years. Assuming a 7 percent return from the stock markets, you’ll have $958,248.54 at age 65. Now let’s pretend you wait until age 35 to get started, but you double-down to catch up by putting $800 per month into your retirement account. If you were to retire at the same age, with the same rate of return, you’d have $906,823.55. Even investing twice as much per month, your 35-year-old self won’t catch up to your 25-year-old self.

The point is, start investing as early as you can, even if you set aside smaller amounts.

An important note: Money that you invest in retirement accounts such as a 401(k) or an IRA generally cannot be withdrawn without a tax penalty until you’re age 59.5. There are some exceptions to the rule, but it’s generally better if you leave the money there for future you to use when you retire.

AAA Member maps out retirement savings plan.

Now's a good time to go through your monthly and yearly finances to determine how much you can afford to put aside for retirement this year.

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How do I start saving for retirement?

Open a 401(k) through your employer.

If you’re employed full-time by someone else, you may have the option of saving for retirement using a 401(k). Your employer may encourage you to sign up by offering to match whatever you contribute up to a certain percentage of your gross income. That’s free money on the table and therefore a guaranteed return, so always take advantage of an employer match if it’s an option. (Employers are not required to offer matching contributions, but it’s still a good idea to participate if they don’t.) 

Let’s say your employer matches up to 5 percent. If you earn $45,000 a year and put 5 percent of your salary ($2,250) into your 401(k), you’d get the full employer match. That means you’ll get an extra $2,250 toward your retirement, which will earn compound interest over time. Plus, your contribution is deducted from your paycheck before any taxes are withheld, which lowers your taxable gross income. That means you’ll pay lower taxes too. 

Once you set up your 401(k), money will often be auto-deducted from your paychecks and deposited in your brokerage account. Although your employer chooses which financial firm provides its 401(k) services, you decide the mix of stocks, bonds, or other investments you’d like to make. After the initial setup, it’s one less mental to-do each month, and you can log in once or twice a year to check your balances. If you’re stressed about what to pick, you can start simple with a target-date mutual fund tied to the approximate year you plan to retire, which is risk balanced accordingly. Then, as you gain confidence as an investor, you can tweak and rebuild your portfolio to match your goals and risk tolerance.

Before you opt in to a company’s matching program, make sure you understand its vesting schedule, which determines when the money it contributes to your 401(k) actually becomes yours. There are three main types of vesting schedules:

  • Immediate: Any money your employer uses to match is fully vested right away and yours to keep whenever you leave the company. 
  • Graded: You get to keep a percentage of the employer match each year, say 20 percent in year one, 40 percent in year two, and so on until it’s 100 percent vested. If you left after year one, you’d only get to keep 20 percent of your employer’s contributions.
  • Cliff: You get nothing until you are fully vested, often around five years of employment.

Remember: You always get to keep the money that you contribute. Vesting is just about the employer match.  

Open an IRA account on your own.

You can opt to use an Individual Retirement Arrangement, or IRA, in addition to your 401(k) or on its own if retirement benefits are not available to you at your current job. An IRA comes in two forms: Roth or Traditional.

  • Traditional: You get the tax advantage today by contributing pre-tax—the money you put in the account is subtracted from your taxable income for the year, and you only pay taxes once you start withdrawing from the account in your retirement.
  • Roth: You can take your money out tax-free in retirement, because you fund it with post-tax dollars.

It’s often said that a Roth IRA better suits younger workers, because your tax bracket now is probably lower than it will be in the future and you’re paying taxes on today’s dollars—but honestly, either way, you’re preparing for retirement, which is a big win! 

Smart Tip: In 2020, you may contribute up to $6,000 to a Traditional or Roth IRA. The maximum annual 401(k) contribution is $19,500 (for anyone under age 50).

AAA Member sets up self-employed retirement savings plan.

Self-employed workers and business owners have access to additional retirement plan options.

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How should I save for retirement as a self-employed worker, independent contractor, or prolific side hustler?

An estimated 40 percent of millennial workers nationwide freelance in some capacity as full- or part-time independent contractors. The gig economy is obviously a huge part of how we earn money. However, this means you may not have access to a traditional retirement account such as an employer-matched 401(k). That, however, is not an excuse to put off investing for retirement. In fact, it’s all on you so you need to be proactive about getting started and being consistent. 

You can still use the Traditional or Roth IRA options. But because you’re self-employed, you don’t have to tap out at contributing $6,000 a year. You also have these additional options available to you:

  • SEP IRA: The SEP IRA allows you to contribute up to 25 percent of your annual compensation with a cap of $57,000. That means if you earned $100,000 this year, you could contribute $25,000 to retirement. That’s a huge improvement over the $6,000 cap for Roth and Traditional IRAs. Even if you earned $50,000 this year, that still means you could contribute up to $12,500. 
  • SIMPLE IRA: The Savings Incentive Match Plan for Employees IRA is often best for small-business owners with 100 or fewer employees. However, you are usually required to provide an employer match, which is not required for a 401(k). There is a cap of $13,500 in 2020 for individual contributions.
  • Solo 401(k): There’s a total contribution limit of $57,000 in 2020, but similar to the SEP IRA, a Solo 401(k) depends on your earned income. You can’t contribute to a Solo 401(k) if you have employees, but it’s an option if you’re a sole proprietor. 

For the self-employed, it’s always wise to consult an accountant before deciding which retirement strategy would serve you best based on how your company is organized and projected to grow, especially if you plan to hire employees.

How much should I invest each year?

Everyone always wants to know if they’re putting enough into a retirement account. 

While it’s ideal to max out a retirement account each year if you can ($19,500 for a 401(k) and $6,000 for an IRA for those under 50 years old in 2020), it may be unrealistic. Instead, contribute what you can and try to get the full employer match on a 401(k), because it’s essentially free money. Is the full employer match too much for your budget? Start with 1 percent and then push up your contribution another 1 percent every six months. You likely won’t feel the pinch as you slowly work toward your goal. Check with your plan’s provider to see whether there are limits to how many times a year you can increase your contribution. 
For those investing in an IRA, set a goal for how much you want to hit this year and do the math. If that goal is $4,000, then $4,000 divided by 12 equals $333.33 per month. A monthly investment can often be easier to manage (and less painful) than making a yearly lump-sum deposit.

Really, how much you should be investing each year is not about arbitrary benchmarks or thou-shalt-have-big-numbers. It’s about knowing the lifestyle you want in retirement and planning accordingly. Instead of following advice offered with clickbait headlines of “you should have X saved for retirement for each decade of life,” these are the factors to consider:

  • Where do you want to live? 
  • How much money do you think you’ll need annually for living expenses?
  • Do you anticipate certain medical costs based on existing health issues or family history?

If guestimating what your expenses will be later in life seems daunting, focus on stashing at least 10 percent of your salary in retirement accounts each year. It’s important to keep in mind that maxing out an IRA alone may not be enough to reach that goal. You may need other investments as well.

Should I open a Health Savings Account?

Health care is one of the biggest financial concerns in retirement, which is why it never hurts to start preparing early. Really early. If you currently have a high-deductible health plan, then you should see if you also have access to a Health Savings Account. In most states, an HSA allows you to invest pre-tax dollars, which you may spend on qualifying medical expenses without being taxed upon withdrawal. In many states in the West, you also are not taxed on the money you earn on your HSA account balance. California residents, however, must declare any capital gains, interest, or dividends on their state tax returns.

The best part about an HSA is that the funds roll over from year to year, so you can save for a big upcoming event (such as a pregnancy or a necessary surgery) while squirreling away money for future  medical needs. 

Keep in mind, an HSA is different than a Flexible Spending Account, which allows only a max of $500 in unused funds to roll over to the next year.

AAA Members review household finances together.

Major life events such as getting married or buying a house are a good time to review your current retirement plans and account balances.

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How else can I prepare financially for retirement?

You absolutely need an emergency fund. Ideally, this is a high-yield savings account containing enough money to cover three to six months of bare-essentials expenses (rent/mortgage, food, transportation, bills/debts, etc.). You can easily earn more than 1 percent in interest on your account, which is important, because so many savings accounts offer a measly 0.01 percent.

You also should have a life insurance policy, especially if you have any co-signed student loans that aren’t discharged in death. For many millennials, a simple term life insurance policy is all that’s necessary. Depending on the size of the policy and your age, gender, and health, the cost of a term life policy could be as modest as $20 per month. 

“I have seen life insurance help with a distraught family after a loved one passes,” says Don Mandel, a AAA life insurance agent for Northern California, Nevada & Utah. “It, of course, does not bring them back, but it can provide financial security and offer time for the family to grieve.”

Even if you’re thinking that you don’t have many assets, consider whether anyone else depends on your income. “A good question to ask is, 'What [would] the loss of income be if your spouse passed away unexpectedly?'” says Shannah Compton Game, a Los Angeles-based certified financial planner and host of the Millennial Money podcast. “Also, consider any mortgage or other debt that you’d want to pay off with the life insurance proceeds.” She usually suggests having eight to 10 times your income as your policy. 

Consider your income replacement, mortgage balance, children’s education accounts, and funeral expenses as some of the main factors when evaluating your life insurance needs. Mandel recommends purchasing more than you think you may need—and for longer. “The value of $250,000 will not be the same in 20 years, and 20 years goes by much faster than you think,” he says. 

The key is to start now.

This is a lot of information to take in, which can feel really overwhelming. Don’t fret. Take a small step this week to put yourself on the right path: Go online or call an investment brokerage to set up an IRA, or ask your company’s human resources department how to sign up for its 401(k). Already signed up? Bump up your contribution by 1 percent if you aren’t already maxed out. The most important thing you can do is get started now. Future you will thank you.

Erin Lowry is the author of Broke Millennial: Stop Scraping By and Get Your Financial Life Together and Broke Millennial Takes On Investing: A Beginner’s Guide to Leveling Up Your Money. She lives in New York City with her husband and their rambunctious dog.

The examples here are based on simple calculations to illustrate the methods behind saving for retirement. It’s always best to consult your accountant or financial advisor to determine the best retirement savings strategy for you.